FIGURE 1 - Relative performance of 11 major market sectors for 2023.
The first trading day of the fourth quarter of 2023 will be Monday, October 2. This is as good a time as any to analyze the market through the lens of sector performance through the first three quarters of this year. Our objective with this analysis is to understand how the trading year has played out, and what is in store for the markets in the fourth quarter. With this understanding, we can best position capital to close out this year and prepare for the next.
A look at Figure 1 below plots the year-to-date relative performance of all 11 market sectors. A few takeaways are quickly evident from looking at market data plotted in this manner. The first take-home point is that overall financial market returns have not been broad-based through the first three quarters as the S&P 500 has returned 11.68%. Second, while this is a fine return, general concern about its sustainability has been present for some time now. The narrative throughout the year has been much handwringing about a possible approaching recession. When is the Fed going to make interest rates too high? When will trends that kept consumers in a relatively strong position fade? When will the recession come? So far, the investors who were willing to stay in certain segments of the market have benefited handsomely. Heck, even a simple S&P 500 tracking ETF would have you in double digit returns.
The heavy lifting has been done by 3 to 4 sectors, while most of the market floundered. To be specific, the sectors performing well have been semiconductors, consumer discretionary, and energy. Semis and consumer discretionary have been the clear-cut winners for the year. Think of energy as the late bloomer; that is the XLE in Figure 1 pale blue setting a noticeable uptrend starting in late June. As we sit at the dawn of Q4 2023, energy has just broken away from the pack and looks poised for more growth at year’s end.
Consider the driving factors for these well performing sectors, and you can understand the overall market. The semiconductor sector has been driven by enthusiasm around artificial intelligence, data storage and processing, and a general increase in demand for consumer electronics including autos. The consumer discretionary sector has done well because of the robust and unyielding health of United States consumers. Roughly 70% of the United States GDP is the consumer economy. As the United States economy has held up very well in the face of a rising interest rate environment and troublesome inflation, the consumer discretionary sector has benefited tremendously. Lastly, the energy sector is finally benefiting from strong United States economic growth. The combination of robust demand in a nicely expanding economy with geopolitical factors causing recent reduced global oil supply has driven oil prices up since the summer. As go prices for the commodity, so goes the energy sector.
Looking into Q4 2023, the narrative for the markets will almost assuredly continue to center around the labor market, inflation, and interest rates. The labor market is getting a lot of attention because the Fed is worried that inflation will be unable to come down with such a high demand for workers and therefore upward pressure on wages. As of late, the labor market is showing some signs of softening. For each of the past three months of June, July, and August, the US economy added fewer jobs than it has in any single month from January through May 2023. The August unemployment rate also ticked up to 3.8% from a previous 3.5%.
Considering inflation, the bulk of the problem has been corralled. However, the last mile of the race tends to be the hardest. The downtrend in US inflation rate was broken in July 2023 when the rate moved to 3.2% from 3%. August was no better at 3.7%. The Fed’s preferred gauge, core personal consumption expenditures inflation, is also staying persistently elevated. We have all heard many times over about how the Fed is attempting to manufacture a “soft landing” for the United States economy. In service of this goal, the Fed acted aggressively; interest rates were raised 500 basis points from March 2022 to May 2023. Now the Fed is waiting to see the fruits of this rapid change in rates. It is reasonable to understand it takes many months for such a change in interest rates to work its way from the federal reserve system of banks to the broader economy.
The Federal Open Market Committee will hold two more meetings in 2023. The next is scheduled from October 31 to November 1. Federal reserve chairman Jerome Powell has stated in August that inflation is still “too high” and “we are prepared to raise rates further”. Whether another 25 basis point hike occurs or not, we are nearing the end of the raising interest rate cycle. Therefore, we must be sensitive to asset allocation as we transition from a rising to a potentially steady or even falling interest rate environment.
With these thoughts as our backdrop, the following guidance for asset allocation seems reasonable. Consider these items in addition to looking at the charts of individual sectors with recent short term trendlines and SMA 50, 100, and 200 plotted for each in Figure 2.
1. Going long semiconductors and consumer discretionary stocks does not seem to be a favorable trade given the tremendous run up these sectors have enjoyed so far this year.
2. The fundamentals for the healthcare and energy sectors seem attractive. If the checks on global oil supply continue, the energy sector should have a tailwind. Healthcare is a traditional defensive sector, which may make sense if you are concerned about growing recession risk. From a technical standpoint, healthcare is showing a clear uptrend which is more than we could say for every other market sector. The healthcare sector is diverse. In future posts, we will drill down on which industries within healthcare look most attractive.
3. If the “higher for a longer” narrative rings in your mind, consider value stocks. High interest rates have historically hurt high growth stocks because of the deleterious effect on their discounted cash flow valuations.
FIGURE 2 - Individual charts for each of the eleven major market sectors. Note the clear uptrends in XLE and XLV. Data as of October 1, 2023.
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